As emerging markets (EM) mature into the drivers of global growth, the structural case for investing in EM debt has become compelling. Once regarded as a niche asset class, EM Bonds have rapidly evolved into a fully integrated segment of the global bond market and are now a growing component of investors' portfolios.
In fact, the size of the EM bond market has grown by an average of over 20% per year between 2004 and 2015 to over US$16 trillion or more than 12% of all bonds issued globallyi. This highlights the case for increasing exposure to the high-yielding, yet secured asset class.
Five Drivers of the EM Bond Market
Stronger economic growth
Over 70% of global growth is forecasted to come from EM in 2015. While growth rates diverge across the universe of EMs, they are on average growing twice as fast as developed markets (DM)ii . Their biggest growth drivers are a growing middle class, increasing consumption spending, rapid urbanization, and accelerated infrastructure development and reforms.
Greater fiscal and monetary stability
The debt-to-GDP ratio of EM has fallen dramatically since the turn of the century, giving EM policymakers greater flexibility to implement fiscal and monetary policies that facilitate macroeconomic growth and stability. Comparatively, the debt-to-GDP ratio of DM has been increasing. Currently, the debt-to-GDP ratio of developed countries is on average about 111%, compared to 38% for emerging markets,iii putting EM economies on a stronger footing.
Larger foreign reserves
EM has significantly larger foreign reserves than DM, giving their governments the ability to repay their external debt and maintain currency stability. The foreign reserves of the largest EM currently amounts to US$5.1 trillion compared to US$ 1.5 trillion of the largest DM.iv Large foreign reserves in EM countries are also an important determinant of their improving credit ratings.
Improved credit ratings
The risk premium of EM debt has declined significantly in recent years, resulting in significant improvements in their credit ratings. Using the JP Morgan EMBI Global Diversified Index as the EM debt benchmark determinant, 65% of EM bonds are currently rated investment grade, compared to only 2% in 1993.
Declining risk of default
The attractive macroeconomic profiles, improving credit ratings, and higher foreign reserves of EM put them in a better position than DM to repay their debts, thereby lowering their risk of default. As well, a greater portion of EM debt is now issued in local currency, further reducing the probability of default.
Five things to consider when investing in EM bonds
EM bonds offer significantly higher yields than DM bonds. On average, the yield of DM bonds are currently below 2%, compared to 6% for EM bonds.v
Historical long-term outperformance
EM bonds have outperformed in 12 of the last 16 years from 1999 to 2014 with 10.7% compounded annual growth rate compared to 5.3% for DM bondsvi
Greater diversification and low correlation
More than 60 different EM countries issue bonds, providing geographic, credit quality, duration, and currency diversification. EM bonds have a low correlation to other asset classes, therefore represent a significant opportunity for portfolio diversification and volatility and risk reduction.
A greater amount of EM bonds are rated investment grade, lowering the risk of investing in EM bonds. The growing issuance of local currency bonds also makes these bonds less susceptible to swings in major currencies such as the US dollar or Euro, thereby reducing currency exposure risk.
Active management allows for tactical shifts in country, currency and interest rate risks based on changing market conditions to enhance returns.
- Credit Suisse: Emerging capital markets: The road to 2030, JP Morgan
- International Monetary Fund, World Economic Outlook, April 2015
- CIA Word Factbook, 2014; IMF World Economic Outlook, April 2015 (EM debt average includes Brazil, India, Philippines, South Africa, Colombia, Mexico, South Korea, Turkey, Indonesia, China and Russia. DM debt average includes Japan, Canada, UK, Germany, and the USA.)
- Bloomberg as of June 18, 2015 (EM consist of China, Brazil, India, Mexico, Turkey, Indonesia and Russia. DM Consist of Japan, France, Canada, UK, Italy, Germany and the USA.)
- EM Yield is based on Blended 50% JP Morgan EMBI Global Composite TR Index and 50% JP Morgan GBI EM Global Diversified TR Index. DM yield is based on BAML US Corporate & Government Master. As of May 31, 2015
- DM bond – Barclay US Aggregate Index. EM bond– JP Morgan EMBI Global Core Index. CAGR is calculated from 12/31/1998 to 12/31/2014 in USD